In June 2005, Nifty hit a new high, surpassing its 2000 peak for the first time in five years. Jim Rogers' book “Hot Commodities” was a bestseller. Commodity prices were rising. I was running a long-short fund with a UK-based hedge fund manager. I wanted to join this trend. I went to meet the promoter and CEO of a small steel company to assess whether I should buy shares. He started the meeting by asking me a question. He said, “Dheeraj, on the business channel this morning after Nifty has more than doubled, it seems all the fund managers are excited about the market. Where were you two years ago?” I politely replied, “If you tell me why you are expanding your production capacity today when steel prices have already doubled from the lows two years ago, I can explain. Shouldn't you have expanded your production capacity then and sold the steel today to make a profit?”
The answer is the same for both: the flow of money. Business cycle theory, developed by Austrian economists, holds that all business cycles are driven by the money supply. But that's a discussion for another day. In 2002, when steel prices were $300 per ton, no one wanted to fund steel projects. When it was $700 per ton in 2005, funds became available. Equity funds had outflows in 2002-2003, whereas in 2005 they had inflows.
The strongest bull market in India was between 2002 and 2007. During this six year period, Nifty grew 4.5x i.e. 40% per annum. I used to quiz fund managers who were in the market during that period: “How did the market perform between 2002 and 2007 and how many double digit corrections did it have?” Most of them remembered the massive rise of Nifty by about 5x but not the corrections. Most of the answers were that there may have been one or two corrections close to 10% but they were not major. During this period, there were two falls of over 30%, three falls of over 15% and a few falls of around 10%. Even within the major cycles, we see significant counter-cyclical moves.
While overall market returns are non-linear, sectoral and stock performance is more cyclical. From 2021 to September 2023, Nifty has risen just 14%, in line with the S&P 500. Midcaps have been on a roll, with the midcap index up 33% in the same period. The most interesting phenomenon is the dispersion of performance within largecaps. The top five stocks in the Nifty have risen 60% to 100%, while the bottom five have fallen 20% to 43%. The current leaders were laggards in the pre-COVID market cycle and vice versa.
Top 5 and bottom 5 performing stocks in Nifty from January 2021 to September 2023
“Nothing in investing works all the time because the environment is constantly changing, and investors' efforts to adapt to it further change it,” Howard Marks wrote in his book Mastering the Market Cycle. Indeed, the environment has become favorable for small and medium-sized companies. Growth capital (both debt and equity) is readily available. Earnings momentum is outpacing large-cap stocks. As a result, investor enthusiasm has become a self-fulfilling prophecy. Ambit Capital strategist Bharat Arora estimates that total inflows (inflows by small and medium-sized funds or allocations to small and medium-sized stocks by large funds) into mid-cap stocks over the past year (August 2022 to August 2023) were $10 billion. This is 20% more than inflows into large-cap stocks. The current mid-cap bull cycle has lasted about three and a half years (since the March 2020 lows), with the index up an astounding 287% (47% annualized). But this is eerily similar to the cycle from September 2013 to December 2017 (a little over four years), when the index rose 245% (32% annualized). Many small cap funds were overwhelmed by a flood of liquidity in 2017 and stopped taking in new money. This one seems unstoppable.
“Trends create their own reasons for reversing. Success carries within it the seeds of failure.” – Howard Marks, Mastering the Market Cycle
Demand for midcap stocks seems insatiable and supply, following the laws of economics, is meeting demand. Jefferies expects equity supply to reach a record $35 billion (Rs 2.8 trillion) in FY24. In 9MCYTD, there have been over 100 promoter/PE sales totaling $19 billion (Rs 1.5 trillion). There are also early warning signs. According to Ambit Capital research, the smallcap index rose 1.9% in September while midcaps fell, indicating the market is becoming selective.
Are we at that stage already? It's always difficult to predict cycle reversals. But you can spot the signs and prepare for them. And there are plenty of signs that popular stocks are risky. I recommend a sharp focus on the quality and sustainability of earnings, as well as valuation. George Soros' strategy of rushing to buy when he sees a bubble forming is based on the belief that he can jump on it before it bursts. This is a rare skill.
As Berkshire's Ajit Jain puts it, “It's easy, until it's not.”
(Dheeraj Agarwal is Managing Director at Ambit Investment Managers. Opinions expressed are his own)
